Undue Commercial Real Estate Risks Are Bad: The Mathematical Proof of the Blindingly Obvious

by Dechert LLP

photo of Rick JonesI was entertaining myself early this morning by looking over a joint agency report just released entitled “An Analysis of the Impact of the Commercial Real Estate Concentration Guidance”. This report summarizes the performance of bank CRE portfolios following the issuance of interagency guidance in 2006 entitled “Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices”. Everyone will be shocked, shocked to know that through the course of the worst recession in post-war history, banks lost money because of commercial real estate exposure and many smaller and regional banks went casters up. Well, there’s startling news. We taxpayers pay for this sort of thing. Where is the sequester when we really need it?

Now I can’t quibble with the data or much of the analytics. This report looked at the performance of the 7,000 plus insured depository institutions, and focused on those who had high CRE concentrations. By high, we’re talking institutions where construction, land and land development loans (CLD, to the trade) represented 100% or more of a bank’s risk-based capital and institutions where total investment (as opposed to owner-occupied) CRE (including the CLD portfolio) represented 300% or more of an institution’s risk-based capital. That, by the way, describes almost all regional and community banks. So which way is the causation arrow pointed? That seems to be a question the authors found curiously uninteresting.

While many conclusions are drawn from this data, the headline, above the fold, marquee conclusion is:

During the three year economic downtown, banks with high CRE concentration levels, proved to be far more susceptible to failure.

I’m breathless. Really?

I suspect equally rigorous academic studies could have come up any of the following headline conclusions:

  • Small, Poorly Capitalized Banks Fail a Lot
  • Banks in Geographic Areas Where the Economy Sucks Didn’t Do Really Well During a Really Bad Recession
  • Banks With Nothing Else to Do Except Make CRE Loans Probably Didn’t Do Very Well, or
  • Banks Run By Dopes Fail a Lot

The 2006 Guidance, which was certainly not a hot read, actually doesn’t impose a cap on CRE lending, but simply suggested that banks with high concentrations of CRE lending should have good practices, protocols and a knowledge base to justify being so concentrated in that space. Nothing to quibble about there. (Although one might observe that our policy of encouraging formation of lots of small banks with limited capital and a limited geographic footprint almost dooms those institutions to embrace over concentration in the CRE space as there is often precious little else to do.)

The problem, of course, is how something like this gets woven into a narrative that commercial real estate is a dodgy business full of executives whose compensation has not been “fairly” restrained by the populism-fed political fury unleashed on the banks and the real estate “moguls” somehow have suborned the world of Jimmy Stewart-led banks to do dumb things that probably should be illegal. It gets wound into the narrative not as a dry, unexciting and perfectly commonsensical notion that small banks with limited management systems should probably avoid excess concentrations of lending activities in asset classes in which they have no strong knowledge base but as part of the broad miasmic hostility to CRE capital formation. We have over 7,000 banks scattered across the country, many of which are in communities where everything is essentially a real estate loan, and those loans are probably as good as or better than the commercial loans which do not have the benefit of a mortgage on some dirt. When the whole world flirts with a depression, these loans will not work really well. I need a long, laboriously compilied academic report full of rigorous mathematics to figure that out?

This is not news and my anxiety here is mostly a concern that some will misuse this report as part of a narrative that commercial real estate is a source of all evil and needs to be more highly regulated (read, constrained) just at the time where we need the banking market, as well as other lending sources in this country, to meet the needs of the commercial real estate industry. Without that support, economic activity in general will be depressed.

We in the commercial real estate industry need to be vigilant that the narrative, like a metastasizing virus, doesn’t get used to further both political and regulatory hostility to CRE capital formation and commercial real estate.

OK, maybe I’m over-reacting, but I was thinking about taxpayers’ dollars at work and wondering why we really needed an interagency report to tell us that a lot of commercial real estate loans went bad when the commercial real estate market collapsed, and a lot of small banks got left holding the bag? A man bites dog moment it ain’t.


DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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